Idea of the Week: Unravelling the Investment Logics of Oil Bonds

• The oil price is at a higher level, which is favourable to oil companies. While the relatively high oil price environment persists for a long period of time, demand destruction does not occur, which reflects a certain degree of stickiness in oil demand. The oil demand is expected to remain stable.

• The capital expenditures by global upstream oil and gas producers remain at a lower level in the past decade. The prolonged underinvestment in the industry gradually impacts the supply side. With oil companies continuing to "lay flat", we can expect the tighter supply to continue going forward. It is difficult for oil prices to fall significantly.

• OPEC+ might also face the dilemma of increasing production due to years of underinvestment in the past. In addition, while OPEC+ hopes oil prices would remain high, it provides strong support for oil prices.

• The US released massive amount of strategic oil reserves, leading to a nearly 40-year low in total crude oil inventories. The action of replenishing oil reserves lead to difficulty in oil prices to fall further. Russo-Ukrainian War had limited impacts on the oil supply for the time being. But the subsequent impacts might not be priced in oil prices. The oil prices might increase again.

• We are bullish on oil prices to remain higher for much longer. Oil Producers would thus benefit. The oil bonds are generally less volatile than oil company stocks. The coefficient of safety for oil bonds is higher. Besides, oil bond yields are generally higher than the yields of the non-cyclical sector bonds with similar ratings, so investors could still consider oil bonds as a yield pick-up.

The US Inventories are Not Sufficient; Replenishing Oil Reserves lead to Difficulty in Oil Prices to Fall Further

Starting in May 2022, in response to high inflation, the US would release 1 million barrels of oil per day (about 1% of global demand) from its strategic oil reserves for consecutive six months. After OPEC+ announced a production cut, President Joe Biden changed the original October halt in reserve releases, and released another 10-15 million barrels in November.

As shown in Chart 5, US strategic oil reserves fell sharply to approximately 370 million barrels (as of January 2023), resulting in insufficient local inventories, with a nearly 40-year low in total crude oil inventories. In addition, the sudden increase in market supply at that time distorted oil prices in the second half of 2022.

But ironically, due to the lack of local inventories, Biden said he would replenish oil reserves below $67 - $72 WTI, which will give oil prices support in these price ranges. It is difficult for oil prices to fall further.

Chart 5: US Crude Oil Inventories (Including Commercial and Strategic Petroleum Reserve)

Russo-Ukrainian War had Limited Impact on Oil Supply for the Time Being; Subsequent Impacts might not be Priced in Oil Prices

The market generally believes that the war between Russia and Ukraine is the main reason for the current high oil prices. In fact, the Russo-Ukrainian War had limited impacts on the overall oil supply for the time being. Russia is still producing a lot of oil. On the contrary, the Russo-Ukrainian War exposed the problem of the energy shortage in Western European countries, leading to an energy crisis.

As shown in Table 2, if we compare the production before and after the war (before the war: January 2022; after the war: September 2022), Russia's daily oil production only dropped by 3.5% (390,000 barrels), accounting for only 0.4% of the global production. The impact is really limited. Therefore, even after the end of the Russo-Ukrainian War, we expect a low chance of a large decline in oil prices.

Table 2: Comparison of Oil Production between Countries Before and After the Russo-Ukrainian War

China and India do not mind importing oil from Russia, so Russia can export most of the oil, which cannot be exported to Western European countries, to China and India, even if there is the boycott of Western European countries. Besides, it is difficult for Western European countries to replace their energy dependence on Russia simply by being self-sufficient or significantly increasing oil imports from other countries. As such, the Russia's oil production only slightly decreased, an embarrassing situation.

The EU oil embargo on Russia and the imposition of a price ceiling on Russian oil (initially at $60 per barrel) are effective since December 2022. These are not yet fully priced in the oil prices. It is estimated that around 2 to 3 million barrels per day (around 2% to 3% of global production) of Russian oil supply will be affected when the embargo comes into effect. If Russia does not have ways to redirect these sanctions-affected oil to other countries or Russia just simply cut the oil supply, oil prices might rise again.

Bullish on Oil Prices to Remain Higher for Much Longer; Oil Producers would Benefit

Looking forward, on the demand side, China’s city lockdown measures were relieved. It would increase the energy consumption in the short-term. The supply of renewable energy is not sufficient to replace fossil fuels in the short-to-medium term. Denuclearization of some European countries is expected to bring them back to fossil fuels. Long-term developments in developing countries (e.g. India, with a population of about 1.4 billion) will also drive demand for oil.

On the supply side, short-term factors to support the oil prices include (1) storage shortages, (2) European Union’s sanctions against Russia, (3) OPEC+’s hopes on oil prices to stay high and (4) international tensions and military conflicts in some regions, which might cause oil production in some regions to fall short of expectations.

Besides, there are a number of structural issues on the supply side, including the prolonged underinvestment in the sector resulting in capacity constraints, (2) oil producers’ “lying flat”, (3) many governments in Europe and US discouraging oil exploration activities and infrastructure investment, and the climate change and ESG (Environment, Social and Governance) concerns related to fossil fuels posing pressure on oil producers, leading them to being cautious in ramping up oil production. These factors cannot be solved overnight. Thus, we expect oil prices to remain higher for much longer. The upstream oil producers would continue to benefit.

Oil Bonds are Less Volatile, with Higher Coefficient of Safety

However, oil prices are volatile and the risk of a global recession is still present. If investors are concerned about volatility or a short-term fall in oil prices, they could consider oil-related bonds (oil bonds). They do not need to bet on rising oil prices to make a profit.

Oil bonds are generally less volatile than oil company stocks, mainly because the company's profitability is directly linked to oil prices, and stock prices are more correlated with oil prices, while the bond prices depend mainly on the company's solvency. Even if oil prices fall unexpectedly, this does not mean that the company's credit risk increases. That said, even if we look wrong on oil prices, investors can still make profit by investing in oil bonds. The coefficient of safety is higher.

As mentioned, the industry norm is that they tend to put higher priority into debt reduction and increases in shareholder returns, rather than increasing capital expenditures. That said, the balance sheets of most oil companies would improve significantly as the high oil price environment persists. Massive free cash flows are available for debt reduction and debt repayment. The credit risk of most upstream oil companies (oil and gas producers) should be manageable in the short to medium term.

It is noted that along with the deleveraging of these oil companies, their credit ratings are expected to improve. This would narrow the spreads on the bonds and probably allow investors to have capital gain from the bond prices. Moreover, given their significant cash flows, they might choose to exercise their call options. Investors have to pay attention to yield to call when selecting their bonds.

Investors Could Consider Oil Bonds as Yield Pick-Up

For bond investors, the spread level on US high yield bonds are narrowing recently (Chart 6). These bonds are generally less attractive. However, oil bond yields are generally higher than the yields of the non-cyclical sector bonds with similar ratings, so investors could still consider oil bonds as a yield pick-up (see Appendix for details).

Chart 6: US High Yield Spread

Appendix: Some Oil Bonds on Bondsupermart

Declaration: For specific disclosure, at the time of publication of this report, IFPL (via its connected and associated entities) and the analyst who produced this report hold a NIL position in the abovementioned securities.t holds a NIL position in the abovementioned securities.